The Tycoon Report

How Much Money Should You Risk?

Wednesday, July 15, 2009 | Teeka Tiwari

During the next several weeks, be sure to tune into this space every Wednesday to learn eight tips aimed at making you a stronger, more-confident and -- most importantly -- a more-profitable investor.

We plan to cover the following topics, and much more (see below). Last week, I covered the importance of focusing both your mental and your financial capital. (Check out the first installment of this series here.)

This week, I'm going to tackle the thorny question of position sizing! Exactly how much should you put into any one trade?

*Note: As we go through this journey together, I may add to, or consolidate, some of these topics.


Rule No. 2: Position Sizing

The classic mistake I see many investors, both new and seasoned alike, consistently make is over-concentrating their capital into a single position.

In the early days of my investing career, I made this mistake as well.  In fact, there isn't much information out there to tell us how big our positions should be, so we must figure it out through trial-and-error ... probably with a lot of emphasis on "error."

Today, I'm going to show you the best way to size your positions to save you a lot of the pain (and money) that other investors are encountering.

What I've learned from my own investing journey is that our position size must be determined not by how much money we hope to make but instead by how much money we are willing to lose if we are wrong!

That's a subtle but important distinction.

My 3% Rule

Being wrong is just a part of ultimately being right. The key is to make sure that, when you are wrong, you don't lose too much of your equity while you are on the road to being right. My general rule of thumb is to risk no more than 3% of my starting equity on any individual trade.

Let's assume that you have a $40,000 account. Does this mean that you only put 3% of $40,000 into your trade?

No!

The 3% is the amount you are willing to lose if your stock position gets stopped out. In order for this technique to work, it means that you must attach a stop-loss to each of your trades. A stop-loss is an order you put in with your broker that will get you out of the trade when the stock hits a certain point.

We use stop-loss points to manage our risk.

Here's How it Works

Let's work through the above example, 3% of $40,000 is $1,200. That means if our position hits our stop-loss point, our position size is such that we will lose no more than $1,200. To take this a step further, let's assume that we want to buy a $20 stock and we want to figure out how much to put into this new position.

The first thing we have to do, before we buy a single share of stock, is figure out our stop-loss point. (This is such a critical part of managing your own portfolio that I plan to do an entire article on this subject as part of this series.)

Let's assume that we have looked at the stock and we've chosen a stop-loss point of $17 per share.

Once we know where our stop-loss point is ($17), we can begin to work out how many shares we can buy. To do this, we simply divide the amount we are willing to risk ($1,200, which is 3% of $40,000) by the amount of points of our stop-loss is (3 points) from our entry price.

The entry price is $20 and the stop-loss point is 3 points below our entry price, so $1,200 divided by 3 equals 400. So, this tells us that we can buy 400 shares of the stock at $20 with a $17 stop-loss point.

If we get stopped out at $17, our loss on 400 shares (assuming we paid $20 for them) would be $1,200, or 3% of our total starting equity of $40,000.

Keep Your Powder Dry Till Your Guns Start Blazing

By using this approach, we prevent ourselves from over-leveraging our positions and creating unnecessary stress. It also allows us to make several attempts to get into a position without risking too much money.

How many times have you been in a trade, got stopped out and then watched the shares skyrocket higher? This used to happen to me a lot, but when I started using the "3% rule" approach, it enabled me to keep enough powder dry that I could make several attempts to get into a position until I got the trade to "stick" without murdering my capital.

At market bottoms and at market tops, this is a very savvy way of "probing" the market in an attempt to catch big, deep-trending moves without "betting the ranch."

As the position becomes profitable, I start adding to it so I can catch as much of the move as possible while always moving my stop-loss along with the stock price to protect my principal and accumulated profits.

Now that we've talked about how to zero in on the strategies and securities you want to have in your portfolio, and how much money to put into each position, next week we'll move on to how to mitigate risk -- specifically when looking at Exchange-Traded Funds vs. individual stocks.

In the comments section, be sure to tell me how you are applying these strategies and any questions that arise during your journey. I look forward to hearing from you!






Teeka Tiwari
Chief Investment Officer
ETF Master Trader